The IRS released new temporary and final Section 752 regulations on October 5, 2016. Sec. 752 of the Internal Revenue Code and related regulations explain how to allocate partnership debt among partners for purposes of calculating the basis of their partnership interests, which determines their basis for deducting losses and receiving tax-free distributions. In this article, the term partnership includes LLCs treated as a partnership for tax purposes. In some situations, the new regulations make it more difficult for partnerships to manipulate the rules to increase the basis of certain partners for tax planning purposes.
Why do we care?
A partner’s share of partnership liabilities, as determined under the Sec. 752 rules, is added to the partner’s capital basis (cash or property contributed increased by recognized income). That gives the partner more room to deduct partnership losses and/or receive tax-free partnership distributions.
However, a reduction in a partner’s share of partnership liabilities, as determined under the Sec. 752 rules, is treated as a deemed cash distribution that reduces the partner’s basis. A reduction can trigger a taxable gain to the extent the deemed distribution — along with actual cash distributions and actual distributions of certain marketable securities — exceeds the partner’s basis. For these reasons, the Sec. 752 rules are important.
How to Define a “Payment Obligation”
The temporary regulation issued in October clarifies when a partner is considered to have a payment obligation with respect to a partnership recourse debt for purposes of allocating that debt among the partners under the Sec. 752 rules. (Recourse debt is debt for which the borrower is personally liable — the lender can collect what is owed beyond any collateral.)
Without having a payment obligation with respect to a recourse liability, a partner generally can’t be allocated any basis from that liability under the Sec. 752 rules. As in most tax law, there is an exception where a partner can be allocated basis from a recourse liability when a taxpayer related to the partner has a payment obligation with respect to that liability.
The new guidance stipulates that the determination of the extent to which a partner or related person has a payment obligation with respect to a recourse liability is based on the facts and circumstances at the time of the determination. It also lists some specific factors that should be considered.
To the extent that the obligation of a partner or related person to make a payment with respect to a partnership recourse liability is not recognized under this rule, the payment obligation is ignored for purposes of allocating that debt to that partner under the Sec. 752 rules. All statutory and contractual obligations relating to the payment obligation are considered in applying this rule. For example, if a partner guarantees a partnership recourse debt, but he guarantee isn’t legally binding under applicable state law, the guarantee won’t be respected as a payment obligation, and it will have no impact on how that debt is allocated to that partner under the Sec. 752 rules.
The new clarification of payment obligations with respect to partnership recourse debts generally applies to liabilities incurred or assumed by a partnership on or after October 5, 2016. It also applies to payment obligations imposed or undertaken with respect to a partnership liability, other than liabilities incurred or assumed by a partnership and payment obligations imposed or undertaken pursuant to a written binding contract in effect prior to that date.
A partnership can, however, elect to apply all the new rules to all of its liabilities as of the beginning of the first taxable year of the partnership that ends on or after October 5, 2016 (calendar year 2016 for a calendar year partnership). A special transitional rule allows the impact of the new rules to be postponed for up to seven years in some situations when the new rules would be harmful to a partner.
How to Handle Guarantees of Recourse Debt and Exculpatory Liabilities
A second temporary regulation creates a new term called “bottom-dollar payment obligation.” For purposes of allocating recourse liabilities among partners under the Sec. 752 rules, a bottom-dollar payment obligation will be ignored for purposes of allocating the entity’s recourse liabilities under the Sec. 752 rules. In this context, so-called exculpatory liabilities are treated as recourse debts. Exculpatory liabilities are debts that are secured by all partnership property. Therefore, they’re effectively recourse to the partnership, even though no partner is personally liable.
The new guidance also requires partnerships to disclose to the IRS all bottom-dollar payment obligations for the tax year in which the bottom-dollar payment obligation is undertaken or modified.
The regulations are primarily aimed at LLCs that use member guarantees of exculpatory liabilities. Guarantees of LLC exculpatory liabilities have been used “creatively” to increase the basis of certain LLC members. The IRS doesn’t look kindly on these types of arrangements, and the new rules make it more difficult to use them for tax planning purposes. As such, the new rules are unfavorable to taxpayers.
The same effective date and transitional relief rules that apply to the updated definition of payment obligations with respect to recourse debts also apply to the new rules regarding bottom-dollar payment obligations.
This is only a brief summary of the key changes under the new temporary and final Sec. 752 regulations. At Cassady Schiller, we can help you navigate the rules and fulfill your obligations. Feel free to contact us to set up a consultation.